FX Market

Rajiv Bhutani
XIM Bhubaneswar,
International Finance, 2018-2020
 FX Market – Topics
● FX Market Participants
● Correspondent Banking Relationships
● The Spot Market
– Quotations
– Cross- exchange rates
– Bid-Ask Spread
– Triangulation Arbitrage
– FX Spot Trading
– FX Spot Microstructure
● The Forward Market
– Quotations
– Non-Deliverable Forwards
– Forward Premium
– Swaps
● Exchange Traded Currency Funds
 FX Market – Questions
● How is FX market organized
● Who trades FX
● Why FX is traded, when FX is traded
● Why is volume in FX increasing so fast
● What is spot, forward, non-deliverable forward
contract
● What is the role of brokers
● How FX rates are determined
● What is the role of Central Banks
 FX Market Participants
● Participants
– Central Banks
– Big Banks trading for their own account and for their customers
– Corporates
– Retailers
– Pension Funds
– Hedge Funds
– Insurance Companies
● Bank for International Settlement (BIS) 2013 – daily volume of spot and
forward FX trade is USD 4.95 tr
● This is per capital daily trading of 700$ for everyone on Earth
● FX Trading increased by 33% from 2010-2013
● 2019 Feb – J P Morgan said they move USD 5 tr of capital among their
clients daily (it would include both inter-ccy and intra-ccy flow)
 % of Total Reported FX Turnover
Country %FX Trade Country %FX Trade
UK 41% France 3%
US 19% Germany 2%
Singapore 6% Netherlands 2%
Japan 6% Denmark 2%
HK 4% Canada 1%
Switzerland 3% Others < 1%
Australia 3%
 Average Electronic FX
Conversations per Hour (2001)
 FX Market – Main Intermediaries
● Broker driven OTC market
● Main OTC Brokers
– Thomson Reuters
– ICAP
● Thomson Reuters first screen based system was launched in 1982 for the
interbank market
● They also launched a conversational dealing product in 1989 and an
anonymous matching platform in 1992
● Electronic Broking Services (EBS) – a platform owned by a number of big
banks and designed with the express purpose of preventing Thomson
Reuters from becoming a monopoly
● EBS was acquired by ICAP, a British based inter-dealer, in 2006
● EBS – USD 100 bn average daily volume
● Internet platforms – largest have USD 15-20 bn daily volume
 FX Market – Main Intermediaries
● Combined volume of all internet based intermediaries -
> 100 bn per day
● FXAll, Hotspot Fxi, e-speed etc.
● Gain Capital
● These platforms serve a useful purpose in that they
allow small funds, corporate treasuries etc. to directly
deal in the FX market, bypassing the interbank market,
thus reducing costs
● Electronic technology helped smaller banks gain
transparency in interbank markets, now internet is doing
the same for corporate treasuries and smaller funds
 FX Market Structure
● Chicago Mercantile Exchange has FX futures listed
● After Globex increased its trading hours to 24 horus,
trading on CME has increased sharply
● Over 40-45% participants in the CME market are
commodity trading accounts (CTAs) and hedge funds
● Fears of fragmentation of liquidity have not turned out true
● Shrinking of FX trading into a few global centers – Tokyo,
London and Ney York – and bank’s reorganization to match
this reality has actually increased liquidity
● With electronic platforms, there is two-way supply and
demand of liquidity
 FX Market Structure
● Wholesale and Interbank market – 91% of trading volume
● Retail and Client market – 9% of trading volume
● Question: Why international banks trade?
– Speculative
– Arbitrage
– Client driven trades
● Question: Why central banks trade?
– To maintain peg
– To reduce excess volatility
– Increasing/decreasing supply of their currency
– Joint intervention
 Correspondent Banking
Relationships
● The interbank market is a network of correspondent banking relationships,
with large commercial banks maintaining demand deposit accounts with one
another, called correspondent banking accounts
● The correspondent bank account network allows for the efficient functioning
of the FX market
● Society for WorldWide Interbank Financial Telecommunication (SWIFT) allows
international commercial banks to communicate instructions of the transfer of
FX to each other
● SWIFT is a private nonprofit message transfer system with headquarters in
Brussels, with intercontinental switching centers in the Netherlands and
Virginia
● The Clearing House (CHIPS), formerly known as the Clearing House Interbank
Payments System, in cooperation with the US Federal Reserve Bank System ,
called Fed wire, provides a clearing house for the interbank settlement for over
95% of USD payments between international banks
● CHIPS processes an average of $ 1.5 tr of payments everyday
 Correspondent Banking
Relationships
● Example:
● US importer desires to purchase merchandise from Dutch
Exporter invoiced in Euros, at a cost of Euro 750k. US importer
will contact his US bank and inquire about the EURUSD rate. Say
US bank offers a price of 1.3092. If US importer accepts the
price, US Bank will debit US importer’s demand deposit account
$ 981,900 = 750k*1.3092, for the purchase of Euros.
● US bank will instruct its correspondent bank in the Euro zone, EZ
Bank, to debit its correspondent bank account Euro 750k, and to
credit that amount to Dutch Exporter’s bank account. US bank
will then credit its books $ 981,900, as an offset to the $981,900
debit to US importer’s account, to reflect the decrease in its
correspondent bank account balance with EZ Bank
 The Spot Market
● Immediate purchase and sale happens
● But settlement happens on T+2 basis, for USD and a non-North
American ccy
● For USDCAD and USDMXN, settlement is at T+1 basis
● Spot FX trading accounted for 41% of FX Trades in 2013
● 2013 – 87% of FX trading had USD on one side
● 2013 – 34% of FX trading had EUR on one side
● 2013 – 22% of FX trading had JPY on one side
● 2013 – 12% of FX trading had GBP on one side
● 2013 – 9% of FX trading had AUD on one side
● 2013 – 5% of FX trading had CHF and CAD on one side
 Biggest Banks in FX
Overall Mkt Share (%) Non-Fin Corp Mkt Share (%)
Deutsche Bank 14.57 Citi 15.27
Citi 12.26 HSBC 9.49
Barclays 10.95 Deutsche Bank 8.86
UBS 10.48 RBS 7.09
HSBC 6.72 JP Morgan 5.68
JP Morgan 6.60 Societe Generale 5.48
RBS 5.86 Barclays 5.01
Credt Suisse 4.68 BNP Paribas 4.04
Morgan Stanley 3.52 UBS 3.98
Goldman Sachs 3.12 BofA-ML 3.47
 Biggest Banks in FX
Banks Mkt Share (%) Leveraged Funds Mkt Share (%)
Deutsche Bank 17.28 Deutsche Bank 15.77
UBS 14.01 Barclays 13.42
Barclays 13.02 UBS 10.62
Citi 11.93 JP Morgan 8.21
HSBC 7.67 Citi 7.82
RBS 5.65 Morgan Stanley 7.24
JP Morgan 5.16 HSBC 6.06
Credit Suisse 4.72 RBS 5.96
Commerzbank 2.14 Credit Suisse 5.83
BNP Paribas 2.10 BofA-ML 4.07
 Biggest Banks in FX
E-Trading, Prop Mkt Share (%) E-Trading, Multi Mkt Share (%)
platform bank/Ind platform
Deutsche Bank 16.84 FXall 21.70
Citi 14.81 FX Connect 18.71
Barclays 13.69 Reuters 3000 Drct 18.53
UBS 11.42 360 Treasury Sys 15.09
JP Morgan 5.47 Currenex 8.31
RBS 5.32 FX Trading BBG 7.74
Credit Suisse 4.92 Integral –FXInside 4.85
HSBC 4.62 HotSpot FXi 3.34
Morgan Stanley 3.65 Gain GTX 0.79
Goldman Sachs 3.53 SaxoTrader 0.45
 Average Daily Turnover by
Instrument and C/P
Instrument or C/P Turnover USD bn Percent
SPOT 2046 41
With reporting dealers 675 14
With other FI 1183 24
With non-fin customers 188 4
OUTRIGHT FORWARDS 680 14
With reporting dealers 182 4
With other FI 402 8
With non-fin customers 96 2
FX SWAPS 2,228 45
With reporting dealers 1,085 22
With other FI 999 20
With non-fin customers 143 3
TOTAL $ 4,954 100
 Spot Exchange and Cross Exchange
Rates
● GBPUSD 1.5400-1.5405
● USDGBP 0.6491-0.6494
(=1/1.5405-1/1.5400)
● S(EUR/GBP) = S($/GBP)*S(EUR/$) = 1.5405 *
0.7638 = 1.1766
●

● EURUSD, USDJPY and EURJPY

● USDCAD, AUDUSD and AUDCAD
 Quotation & FX Organization in
Banks
● Bid-Ask Spread
● Big Figure
● Small Figure
● 1.5397-1.5402
● Retail vs Interbank bid-ask spread
● Question: How spot dealers are organized in banks?
● Single currency desks vs cross desks – Organizational
Efficiency
● Average traders per trader: 1500 quotes, 400 trades
● Average trade size – 10 mm USD
 Triangulation Arbitrage
● Bank A is buying USD @ EUR per USD = 0.7638
● Bank B is buying GBP @ USD per GBP = 1.5400
● Bank C is selling GBP @ EUR per GBP = 1.1705
●

● Cross-rate implies that EUR per GBP bid should be no lower than
1.5400*0.7638 = 1.1763
● Yet, Bank C is offering to sell GBP at 1.1705!
● Profit: Sell 5mm USD to Bank A to get 5mm*0.7638 = 3.819mm EUR
● Sell 3.819 mm EUR to Bank C for GBP 3.262708 mm = 3.819mm/1.1705
● Sell 3.262708 mm GBP to Bank B to get 5.024570 mm USD =
3.262708*1.5400
● Profit = 24,570 USD
 FX Spot Microstructure
● Huang and Masulis (1999) found that bid-ask spread in the spot FX market
increased with FX volatility and decreased with dealer competition
● Results are consistent with the models of dealer competition
● They also found that bid-ask spread decreased when the percentage of large
dealers int eh market increased
● Lyons (1998) tracked the trading activity of a trader at a large NY Bank over 5
trading days
● The dealer was extremely profitable, with average profit of 100k USD per day on
volume of $ 1 bn
● Lyons disentangled trades into speculative and non-speculative – where dealer
acted as an intermediary
● Dealer’s profits came primarily from non-speculative trades
● Consistent theme with NYSE market markets! Also, speculative trading is a zero-
sum game and in the long run, no trader should have a unique advantage
● Half-life of the dealer’s position in non-speculative trades was only 10 minutes
 FX Spot Microstructure
● Ito, Lyons and Melvin (1998) studied the role of private information in the spot FX
market
● They looked at USDJPY and DM/$ between Sep 29, 1994 and Mar 28, 1995
● Their study provides evidence against the common view that private information is
irrelevant, since all market participants are assumed to possess the same set of
public information
● Their evidence came from Tokyo FX market, which prior to Dec 21, 1994 closed for
lunch between noon and 1:30 pm
● After Dec 21, 1994, the variance in spot exchange rates increased during the lunch
period relative to the period of closed trading
● True for both USDJPY and DM/$, but more for USDJPY, which is expected since
USDJPY trading is more intense in the Tokyo FX market
● They attributed these results to a greater revelation of private information in
trades being allocated to the lunch hour
● This suggests that private information is an important determinant of spot FX rates
 FX Spot Microstructure
● Cheung and Chinn (2001) did a survey and received 142 usable
questionnaires
● They were interested in traders’ perception about news events –
innovations in macroeconomic variables – that cause movements in
exchange rates
● Traders responded that the bulk of the adjustment to economic
announcements regarding unemployment, trade deficits, inflation,
GDP, and the Federal funds rate takes place within one minute
● About 33% traders claimed that full price adjustment takes place in
< 10 seconds
● They also found that central bank intervention does not appear to
have a substantial impact on FX rates, but intervention does
increase market volatility
 The Forward Market
● Forward price is usually higher (premium) or lower (discount) to the spot price
● 1, 3, 6, 9, 12 month quotes are readily available
● For good bank customers, maturities upto 5 or even 10 years forward rates would
be available
● S($/CHF) = 1.0614 S(CHF/$) = 0.9421
● F1($/CHF) = 1.0617 F1(CHF/$) = 0.9418
● F3($/CHF) = 1.0624 F3(CHF/$) = 0.9412
● F6($/CHF) = 1.0636 F6(CHF/$) = 0.9402
● CHF is trading at a premium to USD, and that premium increases out to 6 months
● So, we can say that market expects dollar to depreciate relative to CHF
● So, it costs more dollars to buy a CHF forward
● Alternatively, USD is trading at a discount to CHF, and the discount increases with
maturity
● So, market expects CHF to appreciate vs USD.
 Non-Deliverable Forward Market
● Since government institutes capital controls, ccys of some EM countries
are not freely traded and thus it is not posible to obtain these currencies
in the offshore market to settle a forward position
● Trading in non-deliverable forward market (NDF) exists for many
currencies like Chinese Yuan, Russian Ruble, Indian Rupee etc.
● A NDF contract is settled in cash, typically USD, at the difference
between the spot exchange rate on the maturity date of the contract
and the NDF rate times the notional amount of the contract
● E.G. A long position in a NDF contract on CNY 12 mm with a forward
price of F($/CNY) = 0.1653 would be settled by the long receiving $ 6000
= (0.1658-0.1653) * CNY 12mm from the short if the spot rate at the
maturity date of the contract is S($/CNY) = 0.1658
● This cash settlement is in lieu of the long receiving CNY 12mm, with a
spot dollar value of $ 1,989600 =(CNY 12mm*0.1653), a $6000
difference in sums
 Forward Premium
● Forward premium or discount is typically expressed as an
annualized percentage deviation from the spot rate. Example:
● Forward premium/discount fN,j = [FN($/j) – S($/j)]/S($/j) *
360/days
● E.G. Japanese Yen in USD
● Spot 0.010094
● F1 0.010095
● F3 0.010099
● F6 0.010106
● F3,JPY = (0.010099-0.010094)/0.010094*360/94 = 0.0019
● So, 3m forward premium is 0.0019 or 0.19%
 Swap Transactions
● An outright forward transaction is an uncovered speculative position in
a ccy, even though it might be part of a ccy hedge to the bank customer
on the other side of the transaction
● Swap transactions provide a means for the bank to mitigate the ccy
exposure in a forward trade
● A forward swap transaction is the simultaneous sale of spot FX against a
forward purchase of approximately an equal amount of the FX
● Forward swap transactions account for 45% of interbank FX trading,
outright forward trades are 14%
● Both forward swaps and outright forward transactions are exempt from
new OTC regulations as “swaps” under the Dodd-Frank Act
● Dealers use a shorthand notation to quote bid and ask forward prices in
terms of forward points that are either added to or subtracted from the
spot bid and ask quotes.
 Swap Transactions
● Spot CHF/$ 0.9421-0.9424
● Spot 0.9421-0.9424
●
Fwd Pt Quotes Outright Fwd Quotes
●
F1 3-1 0.9418-0.9423
●
F3 9-5 0.9412-0.9419
●
F6 19-13 0.9402-0.9411
●

● When the 2nd number in a forward point pair is smaller than the 1 st, the forward
points are to be subtracted from the spot bid and ask prices to obtain outright
forward rates
● Note that USD is trading at a forward discount to the CHF
● B-A spread is increasing with time to maturity
● When the 2nd number in a forward point pair is larger than the 1 st, the forward points
are to be added from the spot bid and ask prices to obtain outright forward rates
 Swap Transactions
● Quoting forward rates in terms of forward points is convenient due to:
– Fwd points may remain constant for long periods of time, even with changing spot rates
– Also, in swap transactions, where the trader is attempting to minimize ccy exposure, the
actual spot and outright fwd rates are of no consequence – what is important is premium
or discount differential, measured in fwd points
● Example: A customer wants to sell USD 3m forward against CHF. Bank
do this trade for its customer and hedge itself by selling dollars USD
against CHF
● The bank will lend CHF for 3 months until they are needed to deliver
against the USD it has purchased forward
● The USD received will be used to liquidate the dollar loan
● Implicit is the interest rate differential between the USD borrow rate
and CHF lending rate. Interest rate differential is captured by the
forward premium or discount measured in forward points
 Swap Transactions
● Example Demystified:
● Deal:
● Customer: Wants to Sell USDCHF 3m forward
● Bank: Happily buys USDCHF 3m forward from the customer
● Hedge:
● For hedging, bank sells USDCHF spot in the spot market
● Economics:
● But bank did not had USD, so bank borrowed USD at rUSD for 3m, and then
sells this USD in the spot market, so after selling, bank gets CHF for 3m
● Bank lends this CHF at rCHF for 3m. After 3m, bank receives S*(1+rCHF/4)
● Bank delivers this CHF against the 3m fwd transaction and gets USD in return
● Bank uses the USD to pay off the USD loan
 Exchange Traded Ccy Funds
● An Exchange Traded Fund (ETF) is a portfolio of
financial assets in which shares representing fractional
ownership of the fund trade on an organized exchange
● Like MFs, ETFs allow retail investors to invest in
portfolios of financial assets that they would find
difficult to construct individually
● In 2005, a firm associated with Guggenheim
Investments first offered an ETF on the euro ccy called
CurrencyShares Euro Trust
● Now Guggenheim has a total of 9 ccy trust which allow
investment in big 9 ccys